Monday, May 15, 2006

Mr. Market Plays the Dunce

We've always had a thing for wallflowers.

Travel back in time with us: Microsoft (MSFT) is half the price it was before the bubble popped. Like Dell (DELL), Microsoft has generated more cash, increased its revenues, and grown earnings dramatically over the last 5 years. How has the market reacted to both these stocks? It's beaten them down to a pulp -- and we mean pulp, like that cop's face half-way Tarantino's Reservoir Dogs. Dell and MSFT are at levels too embarrassing to quote; the carnage leaves us queasy.

What are we missing here? Are we fools? Paramours of yesterday's darlings? Does anyone else think that things are so out of whack in technology right now? Intel (INTC) at 14 X earnings and AMD (AMD) at 30 x? AMD nibbles 100 bps market share and the bears come out to pound Intel?

Get real. AMD's history of free cash flow is choppier than Nick Lachey's career. Intel is the girl you want to dance with: She generates tons of cash, has a cleaner balance sheet, and spends more on R&D, critical in the semiconductor space, where product cycles are short lived. A quick look at recent option activity on Intel shares will demonstrate that option players, at least, think the stock will shoot higher in the back half of 06. They're not to blame: on fundamentals alone, Intel is worth $30. Analysts expect earnings to jump as high as 27% next year. We think that the PC category will remain sluggish throughout 2006. 2007, on the other hand, could be a banner year. We also believe that Intel, at less than 16 x forward earnings, sells at an attractive price. In case you're not convinced yet, let us add that Intel turns over its inventory faster than AMD (in 05, inv t/o for INTC was 13.5 x whereas AMD's was 9.3 x), coughs out a modest 2% yield, and ranks as one of the most widely held stocks within mutual funds (over 1,100 mutual funds hold INTC; as of 12/31/05, less than 400 were buyers of AMD).

We can sing this song all night long, baby. We could come up with myriad reasons why Dell, Intel, and Softee are all strong buys here. Sadly, no one will listen to us. This market is on idiot mode and the omnipotent pattern seems to be that fundamentals don't mean shit. Neither do technicals, weather patterns, orange juice prices, shoe shine boy tips, or anything else you think drives the markets. The market's hyped up to be the engine of capitalism, the paradigmatic opportunity to invest in this nation's growth. Hey, why not? Stocks beat T-bills, right?

We laugh.

The market was never a product of the companies that made up the major indexes. It's been -- and remains to be -- a product of the people who hit bid and ask orders all day. The metaphor of market as casino is more apt than you think. And to interpolate Bob Dylan: the bets, they are a changing. In 2000, investors were more than happy to pay 86 x earnings for a share of Dell. Dell's earnings in 2000 were .68 cents. Last year, Dell cranked out $1.29, a 89% jump in profit growth. Likewise, in 2000, investors were quick to pay 62 x earnings for Microsoft's .85 cents in earnings power. In 2005, Softee's EPS was $1.16 but the stock was lucky if it ever saw itself go for 20 x earnings. That same year, Microsoft announced that it was on the verge of releasing its strongest product lineup since the first Windows. The market barely sneezed.

The problem is this: we don't understand the market. We can't. We won't. Only one thing is for certain: the market understands us. Alas, it understands us too well.

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